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Figure 5. External balance and its domestic counterparts

Figure 5. External balance and its domestic counterparts

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Economic performance and outlook



31



Table 2. Current account

Per cent of GDP

1998



1999



2000



2001



20021



Trade balance

Merchandise exports f.o.b.

of which:

Marine products

Aluminium and ferro-silicon

Other industrial products

Merchandise imports f.o.b.

of which:

Consumption goods

Investment goods



–4.5

24.1



–3.8

23.9



–5.7

22.7



–0.8

26.4



1.6

25.7



17.5

3.8

1.7

28.6



16.1

4.2

1.9

27.7



14.4

4.8

2.3

28.4



16.4

6.0

2.7

27.2



16.1

5.5

23.0

24.1



9.2

7.5



9.6

6.8



9.0

6.7



8.2

6.0



7.6

4.9



Non-factor services

Exports

Imports



–0.1

11.9

12.1



–1.1

11.1

12.2



–1.4

12.5

14.0



0.3

14.4

14.1



0.1

13.1

13.0



Factor income, net



–2.2



–2.1



–2.9



–3.3



–1.8



Transfers net



–0.2



–0.1



–0.1



–0.1



0.1



Current balance



–7.0



–7.0



–10.2



–3.9



0.1



1. First 11 months at annual rate for consumption goods.

Source: Central Bank of Iceland, Monetary Bulletin.



The service account, which is dominated by transportation and tourism,

has also contributed to the improvement in the external balance, moving into

slight surplus in 2001 when exchange-rate depreciation discouraged Icelanders

from travelling abroad. A continuation of this trend has kept the service balance

broadly stable, although international developments have adversely affected foreigners’ tourism spending, especially during the post-September 11 period. The

deficit on net factor income from abroad, which largely reflects interest payments

on foreign debt, increased further in 2001 as the latter was boosted by large external deficits in previous years and the depreciation of the krona. It has, however,

returned to previous levels in relation to GDP since then, given lower interest

rates abroad and the decline in foreign debt due to the appreciation of the currency. Net external debt has fallen back below 100 per cent of GDP, but this is still

much higher than the level of around 50 per cent prevailing in the mid-1990s.

Nonetheless, it has sufficed for some credit rating agencies to confirm or upgrade

their ratings outlook for Iceland, citing the flexibility of the economy and its capacity

to rapidly sort out imbalances.

Short-term prospects

Following the recent slump, economic activity is expected to post a moderate recovery in 2003 (Table 3). This reflects some rise in export market growth,

combined with a revival in domestic demand in response to monetary easing and



© OECD 2003



OECD Economic Surveys: Iceland



32



Table 3.



Short-term projections



Percentage change, volumes (1990 prices)



Private consumption

Government consumption

Gross fixed capital formation

Final domestic demand

Change in stockbuilding1

Total domestic demand

Exports of goods and services

Imports of goods and services

Change in foreign balance1

GDP

GDP implicit price deflator

Consumer price index

Unemployment rate (in per cent)

Current balance2

General government financial balance2

Short-term interest rate

Long-term interest rate



2003



2004



0.5

2.0

10.6

2.8

0.0



2.0

2.5

11.2

4.1

0.2



2.8



4.3



4.0

6.0

–0.7



4.5

6.5

–0.7



2.1



3.5



2.8

2.5

3.3

–1.0

0.0



3.2

2.6

3.0

–1.7

0.1



6.0

6.5



8.0

7.5



1. As a percentage of GDP in the previous year.

2. As a percentage of GDP.

Source: OECD.



a rebound in real disposable income. As households are expected to continue to try

and strengthen their balance sheets, the upswing in likely to be gradual in the near

term. Thereafter, however, there will be a boost to demand from the construction of a

new aluminium smelter (along with the expansion of existing capacity), a hydropower

station and partly related public investments. Construction of the hydropower plant

and new public infrastructures is likely to begin this summer. This should bring growth

back to above potential rates. Inflation is nevertheless expected to remain near the

official target, given the balanced state of the economy currently and the assumption

of monetary tightening from late 2003. On the other hand, a moderate current account

deficit may re-emerge during the projection period.

External developments would appear to pose the most important nearterm risk to the outlook. Indeed, there are important downside risks to the projected expansion of Iceland’s export markets. Moreover, the recently completed

privatisation of domestic financial institutions and buoyant expectations regarding

the power-intensive industrial development projects could push up the exchange

rate, which is assumed to be stable in the projections, thereby affecting Iceland’s

currently favourable competitive position. On the domestic side, the high level of

household debt could make for even slower consumption growth than anticipated

and investment may take longer to recover. On the other hand, monetary policymakers should stand ready to place more substantial restraint on activity to prevent



© OECD 2003



Economic performance and outlook



33



the economy from overheating if demand accelerates unexpectedly. Although construction work on the major power-intensive investment projects is likely to peak

only in the middle of the decade, policy will need to tighten quickly if there are

signs that a boom mentality gains hold.

Medium-term issues

Notwithstanding pronounced growth fluctuations and volatile inflation,

the overall performance of the Icelandic economy has remained impressive. In

terms of real GDP per capita, Iceland has lost ground somewhat since the 1980s,

when it bettered the OECD average level by about one-quarter. Still, despite a

continuing plunge in the early 1990s, it entered the new millennium with percapita income around one-fifth above the OECD level, broadly unchanged from

the ratio recorded ten years earlier (Figure 6). This rebound owes much to the policies pursued over the past decade. The successful disinflation of the early part of

the 1990s and macroeconomic policies that emphasised stability and predictability – notably the consolidation of public finances – set the stage for the economic

expansion that developed from the middle of the decade. At the same time,

market liberalisation – in particular financial opening in the context of joining

the European Economic Area – together with privatisation, public-sector rationalisation and other structural reforms fostered entrepreneurship, investment

and economic growth.



Figure 6. Relative GDP per capita

1999 PPPs, OECD = 100

Index

135



Index

135



130



130



125



125



120



120



115



115



110



110



105



1978



1980



Source: OECD.



© OECD 2003



1982



1984



1986



1988



1990



1992



1994



1996



1998



2000



105



OECD Economic Surveys: Iceland



34



Table 4.



The macroeconomic impact of the construction of power plants

and aluminium smelters

Per cent deviation from baseline



GNP

GDP

Average annual GDP growth

Investment

Inflation

Current account (per cent of GDP)

Unemployment rate

Exports

Memorandum items:

Long-term impact on the level of:

GNP

GDP

Source:



2003-06



2007-10



2003-10



4ẵ

4ắ

1ắ

44ẳ

3ẵ

6ẵ



2

3

1ẳ

8ẳ

1ẵ

3ẵ



3ẳ

3ắ



25ẵ

1

5



1





1ẵ

16





8ắ



1

1ắ



Ministry of Finance.



As discussed above, the overheating and build-up of domestic and external imbalances during the rapid expansion of the second half of the 1990s have

been swiftly corrected, and the economy seems set for a new period of growth.

While recent performance bodes well for Iceland maintaining its high standard of

living relative to the rest of the OECD, some weaknesses and distortions persist,

which need policy attention. As discussed in the following chapter, Iceland’s very

high, predominantly foreign-currency-denominated, external debt, which will rise

further with the expansion of power-intensive industries in coming years, involves

some risks. And, although headway has been made in export diversification, it

remains exposed to destabilising external shocks. Housing policy biases capital

allocation away from productivity-enhancing business ventures to an important

degree. The energy and agricultural sectors are still heavily distorted by government policies, and further liberalisation would lead to a significant improvement

in consumer welfare. The trade-off between regional policy objectives and

economic efficiency needs to be addressed. These issues and other unfinished

business in the structural policy area are developed in Chapter IV.

The major challenge over the medium term will be to avoid an outcome in

which investments in the energy sector and power-intensive industries lead to a

new period of overheating and unsustainable external deficits. These investments

will have a huge impact on the Icelandic economy (Table 4).1 The projects are

described in more detail in Chapter IV, which discusses longer-term issues related

to them (such as the implications of the increased importance of aluminium

exports). They comprise a new aluminium smelter in eastern Iceland, which would



© OECD 2003



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